FMSB Annual Report Highlights Progress made in FICC Reform

The UK’s FICC Markets Standard Board (FMSB) has issued its 2017 Annual Report setting out the progress it has made to enhance standards of behaviour in the wholesale fixed income, currencies and commodities markets.

FMSB was established in 2015 following the recommendations of the Fair and Effective Markets Review (FEMR), which was conducted by the Bank of England, the UK Treasury and the UK’s Financial Conduct Authority.

FMSB says it has achieved “significant momentum and has received strong support from market participants and public authorities”. It adds that membership now represents all sectors and users of global FICC markets and accounts for over 80% of sell side wholesale FICC market activity.

The report highlights 27 issues identified by FEMR and says FMSB has analysed 400 UK and international conduct issue, prompting another 26 issues to be identified. It has also carried out an “initial horizon scan” that has identified 20 issues.

FMSB says it has completed the initial horizon scan and segmentation of potential practice areas which require clarification by way of standards and/or statements of good practice and has produced three standards and two Statements of Good Practice. The Board is presently working on the production of five Standards and five statements of good practice, it continues, noting it is also engaged in thematic work in relation to electronic trading and technology in markets and in relation to the identification of common recurring abusive trading practices.

“The impact of technology on FICC markets is a key area of interest for FMSB,” the report states. “Key issues for consideration include principles for controls and responsibilities in the management of trading algorithms, controls and risk management relating to the deployment of algorithms, version control and change management processes and record keeping, and the training of responsible staff. Also under consideration is the examination of trading rulebooks and system outages.”

The report also discusses the relative merits of regulation versus principles-based guidance. It notes, “Many people assume that the legal framework, and the detailed regulation that has been developed to complement this over time, provide a clear description of practices in markets – and how markets should work. In fact, this is not the case.

“The advantage of high level principles is that they are concise, adjust to market developments and allow for innovation,” it continues. “However, their application to market practice requires judgement and this may create uncertainty about how principles apply to particular issues. In contrast, detailed rules are more precise, but their precision means that they may hinder innovation, need to be regularly updated to address new developments in markets and can incentivise “gaming” behaviour. As a result, there can sometimes be a tendency for rulebooks to become increasingly long, legalistic and complex.

“The result of this is that both the law and regulation are silent on significant areas of market practice and cannot cover all of the detailed scenarios and complex practices that arise in innovative and rapidly evolving global wholesale markets,” it adds. “Rules may mean that it is legal or illegal to conduct certain practices but do not specify what those practices are or should be. Good regulation and a sound legal framework are necessary pre-conditions for markets to operate fairly and effectively, but more is required to ensure that users of markets will always receive the best of outcomes. Regulation and the law need to be complemented by market standards which lay out the principles of market practice and how practitioners should deal with each other in situations where regulation and the law are not able to guide them.”

The FMSB also observes that the “repeating nature of market conduct problems is also a function of the frailty of collective memory”. It adds that no matter how intense the experience of failures, as time passes memories recede and those who were witnesses move on from the industry. “The lessons learnt by one firm or one generation do not necessarily pass to the next,” it states. “Creating clear and widely adopted market standards which set out best and unacceptable market practice in enduring form will help to perpetuate market Standards over time and across markets.”

To this end, FMSB says it is attempting to clarify “grey areas” of market practice where ambiguity as to (for example) the appropriate assessment of conflicts of interest between counterparties to a trade creates poor outcomes for market users and undermines fair and effective markets.

It adds that much attention is inevitably paid to high profile cases of conduct abuse, often perpetrated by an individual or a network of individuals who find loopholes in the legal or regulatory frameworks and firm control environments. “Regrettably, there will always be incentives and opportunities for this; the determined actors may find ways around even the best designed controls,” the report states. “These types of deliberate, intentional, abuse are unlikely to be eliminated solely by market standards. Nevertheless, by clarifying grey areas of market practice, our standards should help to pre-empt such malpractice and make it harder to engineer.”

One of the issues raised by FEMR was that market discipline was not operating effectively. Part of the role of FMSB is to provide a structured forum within which market discipline is restored and developed. “Market Standards make it easier for market users to insist on appropriate practices and to take the initiative in doing so,” the report states. “In the past, market participants have not necessarily understood the significance of ambiguous practices or have relied on market regulators to address these. But the size, speed and cross-border complexity of trading relationships in wholesale markets makes this challenging.

“Markets will be fairer and more effective if users, as well as liquidity providers, understand how trading protocols should operate and market discipline operates effectively alongside the regulatory framework,” it continues. “By promulgating clear market protocols, standards take an important step to re-establishing market discipline.”

The report also contains “behaviour cluster analysis” of the previously mentioned 400 cases over a 200-year period, although significantly and rather ominously the FMSB says that some 250 of those cases have occurred this century.

FMSB says an extensive time period is used to capture potentially relevant patterns and to indicate the recurring nature of those patterns. “This work has established that malpractice behaviours are consistently similar over time, across asset classes and across jurisdictions,” it says, explaining that there are some 26 behavioural patterns evident in market misconduct cases. “These patterns repeat and recur over time and across markets despite the continuing promulgation of legislation and regulation,” it says.

Unsurprisingly given the globalisation trend, the report finds “These behavioural patterns do not respect national or jurisdictional boundaries – they are evident internationally.”

The patterns are not specific to particular asset classes and are evident in different asset classes. “This is rational: asset classes do not generate conduct risks – people do,” the report states.

Interestingly, the report also claims that behavioural patterns “readily adapt to new market structures and technologies” and says that FMSB will publish materials indicating each relevant pattern and the source cases from which these are derived, case studies for each pattern and the database of the relevant enforcement cases for reference purposes.

“The analysis has established that a number of behavioural clusters repeat and recur over time and adapt to market structural change,” the report states. “This is not new. It is notable that the US Senate Committee, which examined the conduct causes of the 1929 Crash and which led to the Securities and Exchange Act 1934, took over 10,000 pages of evidence relating to market conduct. The market conduct patterns identified by the US Senate Committee in 1934 are strikingly similar to those evident in conduct cases today.”

Mark Yallop, chairman of FMSB says, “In the past 12 months we have made significant progress in our central aim: to raise standards of conduct in the wholesale financial markets and improve outcomes for market participants by making them more transparent, fair and effective. Everything we have seen and done so far has strengthened our conviction about the need for FMSB and the critical role that it has been created to perform.”

Andrew Bailey, CEO of the UK’s Financial Conduct Authority adds, “Good culture and trust go?hand in hand. And trust is fundamentally about the honesty and veracity of commitments and the reliability of future promises to your customers, investors, creditors and the public authorities. By codifying agreed standards that set out these commitments and are accepted by all its members, FMSB is building an essential foundation for re-establishing public trust in markets again. I am a strong supporter of their work and am very pleased to see the progress made in 2016/17.”